5-1

Money MarketsMoney Markets

Money markets involve debt instruments with original maturities of one year or less

Money market debt issued by high-quality (i.e., low default risk) economic units that

require short-term funds purchased by those that have excess short-term funds little or no chance of loss of principal low rates of return

Most money market instruments have active secondary markets to provide liquidity

Money markets involve debt instruments with original maturities of one year or less

Money market debt issued by high-quality (i.e., low default risk) economic units that

require short-term funds purchased by those that have excess short-term funds little or no chance of loss of principal low rates of return

Most money market instruments have active secondary markets to provide liquidity

5-2

Money Market Yields Money Market Yields

Money market securities use special rate quoting conventions: Discount yields (idy): Interest rate is quoted on an annual basis

assuming a 360 day year as a percent of redemption price or face value

Single payment yields (ispy): Interest rate is quoted on an annual basis assuming a 360 day year as a percent of purchase price

Both may be converted to a bond equivalent yield (ibey) for comparison with bonds

Money market securities use special rate quoting conventions: Discount yields (idy): Interest rate is quoted on an annual basis

assuming a 360 day year as a percent of redemption price or face value

Single payment yields (ispy): Interest rate is quoted on an annual basis assuming a 360 day year as a percent of purchase price

Both may be converted to a bond equivalent yield (ibey) for comparison with bonds

5-3

Money Market YieldsMoney Market Yields

Treasury bills and commercial paper rates are quoted as discount yields

Discount yields (idy) use a 360-day year

Pf = the face value of the security

P0 = the discount price of the securityh = the number of days until maturity

Treasury bills and commercial paper rates are quoted as discount yields

Discount yields (idy) use a 360-day year

Pf = the face value of the security

P0 = the discount price of the securityh = the number of days until maturity

hP

PPi

f

f

dy

360)( 0

5-4

Money Market YieldsMoney Market Yields

Compare discount securities to bonds with bond equivalent yields (ibey)

Convert bond equivalent yields into effective annual returns (EAR)

Compare discount securities to bonds with bond equivalent yields (ibey)

Convert bond equivalent yields into effective annual returns (EAR)

hP

PPi fbey

365)(

0

0

1/365

1/365

h

bey

h

iEAR

5-5

Money Market YieldsMoney Market Yields

Negotiable (or jumbo) CDs and fed funds are money market securities that pay interest only at maturity. These use single-payment yields (ispy)

Negotiable (or jumbo) CDs and fed funds are money market securities that pay interest only at maturity. These use single-payment yields (ispy)

hP

PPi fspy

360)(

0

0

5-6

Sample Calculations of Money Sample Calculations of Money Market YieldsMarket Yields

A $1M investment in 90 day commercial paper has a 2% discount yield, what is the current price of the CP?

A $1M investment in 90 day commercial paper has a 2% discount yield, what is the current price of the CP?

hP

PPi

f

f

dy

360)( 0

$995,000P;90

360

$1M

)P($1M0.02 0

0

5-7

Money Market InstrumentsMoney Market Instruments

Treasury bills (T-bills) Federal funds (fed funds) Repurchase agreements (repos or RP) Commercial paper (CP) Negotiable certificates of deposit (CD) Banker acceptances (BA)

Treasury bills (T-bills) Federal funds (fed funds) Repurchase agreements (repos or RP) Commercial paper (CP) Negotiable certificates of deposit (CD) Banker acceptances (BA)

5-8

Treasury Bills (T-Bills)Treasury Bills (T-Bills)

T-Bills are short-term debt obligations issued by the U.S. federal government

T-bills are virtually default risk free, are highly liquid, and have little interest rate risk

The Federal Reserve buys and sells T-bills to implement monetary policy (open market operation)

Strong international demand for T-bills as safe haven investment

T-Bills are short-term debt obligations issued by the U.S. federal government

T-bills are virtually default risk free, are highly liquid, and have little interest rate risk

The Federal Reserve buys and sells T-bills to implement monetary policy (open market operation)

Strong international demand for T-bills as safe haven investment

5-9

T-Bill AuctionsT-Bill Auctions

13- and 26-week T-bills are auctioned weekly Bids are submitted by government securities

dealers, financial and nonfinancial corporations, and individuals

Bids can be competitive or noncompetitive competitive bids specify the bid price and the desired

quantity of T-bills noncompetitive bidders get preferential allocation and

agree to pay the lowest price of the winning competitive bids

13- and 26-week T-bills are auctioned weekly Bids are submitted by government securities

dealers, financial and nonfinancial corporations, and individuals

Bids can be competitive or noncompetitive competitive bids specify the bid price and the desired

quantity of T-bills noncompetitive bidders get preferential allocation and

agree to pay the lowest price of the winning competitive bids

5-10

The Secondary Market for T-BillsThe Secondary Market for T-Bills

The secondary market for T-bills is the largest of any U.S. money market instrument

22 primary dealers “make” a market in T-bills by buying the majority sold at auction and by creating an active secondary market primary dealers trade for themselves and for customers T-bill purchases and sales are book-entry transactions

conducted over Fedwire

T-Bills are sold on a discount basis

The secondary market for T-bills is the largest of any U.S. money market instrument

22 primary dealers “make” a market in T-bills by buying the majority sold at auction and by creating an active secondary market primary dealers trade for themselves and for customers T-bill purchases and sales are book-entry transactions

conducted over Fedwire

T-Bills are sold on a discount basis

5-11

Federal FundsFederal Funds

The federal funds (fed funds) rate is the target rate in the conduct of monetary policy

Fed fund transactions are short-term (mostly overnight) unsecured loans

Banks with excess reserves lend fed funds, while banks with deficient reserves borrow fed funds

Multimillion dollar loans may be arranged in a matter of minutes

The federal funds (fed funds) rate is the target rate in the conduct of monetary policy

Fed fund transactions are short-term (mostly overnight) unsecured loans

Banks with excess reserves lend fed funds, while banks with deficient reserves borrow fed funds

Multimillion dollar loans may be arranged in a matter of minutes

5-12

Repurchase AgreementRepurchase Agreement

A repurchase agreement (repo or RP) is the sale of a security with an agreement to buy the security back at a set price in the future

Repos are short-term collateralized loans (typical collateral is U.S. Treasury securities) Similar to a fed fund loan, but collateralized Funds may be transferred over FedWire system If collateralized by risky assets, the repo may involve a

‘haircut’

A repurchase agreement (repo or RP) is the sale of a security with an agreement to buy the security back at a set price in the future

Repos are short-term collateralized loans (typical collateral is U.S. Treasury securities) Similar to a fed fund loan, but collateralized Funds may be transferred over FedWire system If collateralized by risky assets, the repo may involve a

‘haircut’

5-13

Repurchase AgreementRepurchase Agreement

Typical denominations on repos of one week or less are $25 million and longer term repos usually have $10 million denominations

A reverse repurchase agreement is the purchase of a security with an agreement to sell it back in the future

Typical denominations on repos of one week or less are $25 million and longer term repos usually have $10 million denominations

A reverse repurchase agreement is the purchase of a security with an agreement to sell it back in the future

5-14

Commercial PaperCommercial Paper

Commercial Paper (CP) is unsecured short-term corporate debt issued by financially reputable companies to raise short-term funds (e.g., for working capital)

Generally sold in denominations of $100,000 to $1 million with maturities between 1 and 270 days

CP is usually sold to investors indirectly CP is usually held by investors until maturity and has no

active secondary market

Commercial Paper (CP) is unsecured short-term corporate debt issued by financially reputable companies to raise short-term funds (e.g., for working capital)

Generally sold in denominations of $100,000 to $1 million with maturities between 1 and 270 days

CP is usually sold to investors indirectly CP is usually held by investors until maturity and has no

active secondary market

5-15

Negotiable Certificate of DepositNegotiable Certificate of Deposit

A negotiable certificate of deposit (CD) is a bank-issued time deposit that specifies the interest rate and the maturity date

CDs are bearer instruments and thus are salable Denominations range from $100,000 to $10 million;

$1 million being the most common. Smaller denomination CDs you can normally see are not negotiable.

Often purchased by money market mutual funds with pools of funds from individual investors

A negotiable certificate of deposit (CD) is a bank-issued time deposit that specifies the interest rate and the maturity date

CDs are bearer instruments and thus are salable Denominations range from $100,000 to $10 million;

$1 million being the most common. Smaller denomination CDs you can normally see are not negotiable.

Often purchased by money market mutual funds with pools of funds from individual investors

5-16

Banker’s AcceptanceBanker’s Acceptance

A Banker’s Acceptance (BA) is a time draft payable (IOU) to a seller of goods with payment guaranteed by a bank

Used in international trade transactions to finance – you may not trust your counterpart, so a bank is involved.

Banker’s acceptances are bearer instruments and salable

A Banker’s Acceptance (BA) is a time draft payable (IOU) to a seller of goods with payment guaranteed by a bank

Used in international trade transactions to finance – you may not trust your counterpart, so a bank is involved.

Banker’s acceptances are bearer instruments and salable

5-17

2011 Money Market Yields2011 Money Market Yields

InstrumentFederal Funds*

CommercialPaper CDs Euro CP

Rate 0.11% 0.17% 0.23% 1.18%

Instrument LIBORBanker’s

Acceptances Euro$ Repo*

Rate 0.27375% 0.22% 0.25% 0.08%

InstrumentTreasury

Bills**Inflation***    

Rate 0.060 2.7%    

Data from the Wall Street Journal Online Money Rates Section April 2011. Rates are for 3 month maturities except as noted.•Overnight; ** 13 week, *** Year over year, all items as measured by the CPI•LIBOR=London Interbank Offered Rate=the rate the banks in London charge for their short-term lending/borrowing

5-18

Money Market Securities Money Market Securities OutstandingOutstanding

  Billions $Instrument 1990 2004 2007 2010Treasury Bills $ 527 $ 982 $1,010 $1,856Fed funds & Repos 372 1,585 2,731 1,656Commercial Paper 538 1,310 2,109 1.083Negotiable CDs 547 1,379 2,149 1,822Banker's Acceptances 52 4 1 1 Total $2,036 $5,260 $8,000 $6,418           % of Total in Given YearInstrument 1990 2004 2007 2010Treasury Bills 26% 19% 13% 29%Fed funds & Repos 18% 30% 34% 26%Commercial Paper 26% 25% 26% 17%Negotiable CDs 27% 26% 27% 28%Banker's Acceptances 3% 0.1% 0.0% 0.0%  100% 100% 100% 100%

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